Japan's Prime Minister Naoto KanISSEI KATO
The severe trouncing of Japan's ruling party in weekend elections is raising fears that political gridlock could derail economic reforms needed to curb the country's crushing debt-load and persistent deflation.
Standard & Poor's is warning it may lower Japan's credit rating in response to the humiliating defeat in Upper House elections suffered by Prime Minister Naoto Kan's Democratic Party of Japan (DPJ).
The debt-rating agency says that while the DPJ remains in power, the government's efforts to reduce the world's largest public debt load - almost twice the size of Japan's economy - will now be more difficult to implement.
"A hung parliament is the most likely outcome, as leaders of opposition parties are rejecting the possibility of joining the coalition. A hung parliament would make it very difficult for the government to push through major policies," Standard & Poor's said.
Mr. Kan had campaigned on plans to raise Japan's consumption tax to 10 per cent from 5 per cent to help reduce the country's soaring debt. After taking over in June as the fifth prime minister in less than four years, Mr. Kan warned that Japan is facing the prospect of a Greece-style economic meltdown if it doesn't implement dramatic policy reforms.
Now the DPJ, which had ended the 55-year rule of the conservative Liberal Democratic Party last year, will be hard-pressed to follow through on its plans to reduce spending and increase taxes in the world's second-largest economy.
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The DPJ won 44 seats in the Upper House, far below the hoped-for 55 seats. The results prompted GaveKal Research to publicly muse whether Japan's long-troubled economy "is incapable of reform."
In a report to clients, GaveKal suggested that the proper policy mix for Japan would be tighter fiscal policy, with an emphasis on spending cuts rather than tax increases, with a "very loose" monetary policy. Such a mix would likely weaken the yen without leading to a collapse in the Japanese Government Bond market.
Politically hamstrung to push through policy reforms, Mr. Kan's DPJ government is now expected to try to lean heavily on the Bank of Japan to ease its already exceedingly loose monetary policy.
Despite its debt issues and troubling inflation, Japan's economy has performed well lately, with GDP increasing 4.6 per cent in the first quarter, the second-fastest among the Group of Eight countries behind Canada.
As well, Japan's debt troubles are less problematic than many countries because the vast majority of government debt is held by domestic investors.
The election losses will make it more difficult for Mr. Kan to push fiscal austerity. But Drummond Brodeur, vice-president and portfolio manager at Signature Global Advisors in Toronto, noted that it was always going to be a hard sell for Mr. Kan because there's no sense of urgency among the Japanese to put the country's fiscal house in order. "Japan has been in a deflationary, stagnant economy for two decades now. So there's no sense of crisis," he said.
Nor is there a sense of crisis in financial markets: Interest rates are near zero and the yen is near its all-time high versus the U.S. dollar.
Mr. Brodeur also pointed out that Mr. Kan was facing dissent within his party on the consumption-tax hike, even before the Upper House election. There's a legitimate concern that raising the consumption tax could hurt Japan's fragile consumer economy, just as it did in the mid-1990s, the last time the rate was hiked, he said.